The Impact of Rural Banking On Poverty and Employment in India

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The Impact of Rural Banking on Poverty and Employment in India
Thesis · October 2019

DOI: 10.13140/RG.2.2.33612.16004
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The Impact of Rural Banking on Poverty and Employment in
Rural India: An Empirical Study
Mazdi Syed
2019
The Impact of Rural Banking on Poverty and Employment in
Rural India: An Empirical Study
___________________
A Thesis
Presented To
Professor Dr. Holger Seebens
Faculty of Business
Die Technische Hochschule Nürnberg Georg Simon Ohm
___________________
In Partial Fulfillment
of the Requirement for the Degree of
Master International Finance and Economics (M.Sc.)
___________________
By
Mazdi Husain Bukhari Syed
2960746
October 2019
ii
Table of Contents
Abstract ..................................................................................................................................... 1
1. Introduction .......................................................................................................................... 2
1.1 Objectives of the Study ..................................................................................................... 5
1.2 Organization of the Study ................................................................................................. 5
2. Background of Study ........................................................................................................... 6
2.1. Bank Nationalization ....................................................................................................... 7
3. Structure of The Organized Banking Sector in India ....................................................... 9
4. Literature Review ............................................................................................................... 10
5. Methodology ....................................................................................................................... 20
5.1. Program ........................................................................................................................ 20

5.1.2. Data Description .................................................................................................... 22
5.2. Identification of Strategy ............................................................................................... 23
6. Basic Results ....................................................................................................................... 34
6.1. Reduced Form Evidence................................................................................................ 34
6.2. Instrumental Variable Evidence .................................................................................... 37
7. Discussion ............................................................................................................................ 47
7.1. Rural Branch Expansion (success and limitations) ...................................................... 47

7.1.2. Further Attempts of Financial Inclusion ................................................................ 49
8. Conclusion ........................................................................................................................... 51
9. Data Appendix .................................................................................................................... 53
Reference ................................................................................................................................. 56
iii
Abstract
Recent evidence suggests that financial mobilization and access to finance are the key
challenges of poverty reduction. In India, despite numerous attempts, a mere 53 percent of the
adult population have bank accounts, which is lower than the global average (of 69 percent)
(The Global Findex Dataset, 2017). This paper provides empirical evidence of the alleviation
of rural poverty by using the data on India’s rural branch expansion program. Between 1977
and 1990, the commercial banks of India were given permission by the Central Bank to open a
branch in a location where one or more bank branches already exist, only if it opened four in
locations where there were no bank branches. This regulation caused banks to open more
branches in rural, less developed Indian states, whereas the reverse was happening, with banks
expanding their operations within cities, outside this period. This paper uses branch opening
data from 1961-2015 and investigates the impact on poverty, as well as on employment for
post-1990. The results show that the rural branch expansion program contributed to reducing
poverty and increasing employment opportunities.

“If you go out into the real world, you cannot miss seeing that the poor are poor not
because they are untrained or illiterate but because they cannot retain the returns of
their labor. They have no control over capital, and it is the ability to control capital that
gives people the power to rise out of poverty.” ― Muhammad Yunus,
While there exist multiple definitions of poverty, the one used for the purpose of this
paper is,
- Poverty is not being able to meet the basic human needs for the lack of money.
Although, in reality poverty is much more than just not having enough money.
1. Introduction
Improving the standard of living and attaining inclusive economic growth is a crucial for
developing countries. In order to do so, finding means of reducing poverty, and ascertaining a
permanent solution on how to lift people out of poverty, breaking the poverty cycle, is essential.
One key factor is financial access, which enables people to transform their employment and
production activities and to exit poverty (Banerjee and Newman 1993; Aghion and Bolton
1997; Banerjee, 2003). Countries with a better developed financial system, it is argued, should
be better able to exploit growth opportunities (Schumpeter, 1912; Gerschenkron 1962;
Greenwood and Jovanovic, 1990; Bencivenga and Smith, 1991). In developing countries, rural
credit markets have been the center of policy intervention (Besley, 1994; Hoff & Stiglitz, 1998).
The idea that governments can use public policy to reduce financing constraints, and thereby
instigate development and reduce poverty, led to the broad implementation of state-led rural
savings and credit schemes in developing countries in the postcolonial period (Burgess &
Pande, 2005). These notions do provide an abstract explanation for an intervention by the
government to the banking sector, but credible, tangible evidence of success in such
intervention of reducing poverty remains limited.
2
This paper is an empirical investigation of the impact of rural banking expansion in Indian and
its efficacy in reducing rural poverty and increasing employment. It is an extension of the paper
‘Do rural banks matter? Evidence from Indian Social Banking Experiment’, by Robing Burgess
and Rohini Pande. Their paper analyzed the branch expansion and licensing policy of the
Reserve Bank of India in 1977 and found that between 1977 and 1990, rural branch expansion
was explicitly targeting the financially less developed states. However, the reverse was true
before 1977 and after 1990, i.e. banks targeted (relatively) financially developed areas to
expand their network. The timing and nature of these trend reversals were caused by the
introduction and removal of the 1:4 branch licensing policy as in between 1961 and 2015, the
number of bank branches opened in rural unbanked locations were much improved, and the
policy resulted in a growth from 104 branches in rural India to more than 29,600 branches. Over
seventy-eight percent of the branch expansion took place between 1977 to 1990, and thereafter,
the expansion in the unbanked location halted due to changes in policy (Burgess & Pande,
2005). This paper uses a set till 2015 (an extension of the original which used data up till 2000),
using the same methodology from the research paper of Professor Robin Burgess and Professor
Rohini Pande. Based on other various arguments against actual effect of branch expansion on
poverty, this paper tests see if branch bank expansion continued further than1990 and if it
actually helped reduce poverty in the rural areas. However, the empirical model is further
altered to include additional information on the ‘rural employment situation in India’ that is
available in the data set.
A sizable literature seems to suggest that institutional credit for rural India is still inaccessible
and trapped in a cycle of unproductivity. While increasing transaction costs and lag in the
banking process taking away borrower's capability and interest to access the banking services.
At the same time the complication in providing service and monitoring large numbers of
3
“small” borrowers in addition to with weak recovery framework is putting the institutional
credit agencies in a fragile position. This in turn eventually hampers the rural credit delivery
system. Unfortunately, after years of systematical effort to make the institutional (formal) credit
comprehensive and reduce the strong hold of the informal credit1 sector, mitigating the
dependency of rural households on it. Yet informal credit still seems to have strengthened in
recent times. To improve access of the rural poor to formal credit and savings opportunities,
the Indian government launched an ambitious social banking program in the year 1969.
Between bank nationalization in 1969 and the beginning of financial liberalization in 1990,
bank branches were opened in over 27,000 rural locations, which had no prior presence of
commercial banks (unbanked locations).2
Critical to the rural bank branch expansion program was the implication of the 1:4 license in
1977. This rule specified that a bank could open a branch in a location with one or more
branches (a banked location) only if it opened four new branches in unbanked locations. This
policy remained in place until 1990 (Burgess & Pande, 2005). The research design exploits the
policy-driven nature of branch expansion across Indian states. In between 1977-1990, rural
branch expansion was moderately higher in (financially) less developed states as opposed to
before 1977 and after 1990. The timeline of this reversal implies they were caused by the 1:4
branch licensing policy.
The fast growth of the Indian branch expansion program between 1977 to 1990 and the
following slow down post-1990 was widely documented (Nair 2000). Through exploiting the
deviation between 1977-1990 and post-1990 to 2015, this paper focuses on distinguishing the
policy-driven output of the rural branch expansion as an instrument, from the linear trend
relationship between states' initial financial development and rural branch expansion. This
1
Generally, a moneylender as an individual or group that usually lends relatively small amounts of money at very
high rates of interest.
2
Locations here refer to villages, towns, and cities as defined by the Indian census.
4
method allows us to segregate problems such as nonrandom branch placement. The research
design considers that alternative state-specific policy and economic variables, which influence
poverty outcomes, and did not exhibit a similar time trend pattern. Also, variables such as states'
economic performance, poverty alleviation policies, and other credit programs, did not show a
similar pattern either. The aim of this paper is to pinpoint the effect of branch expansion into
rural unbanked locations, a policy by Central Bank of India, in relation to reducing rural
poverty.
1.1 Objectives of the Study
The study sets out to empirically examine the effect of financial sector development (rural
bank expansion) on the welfare of rural households. Specifically, the study seeks to achieve
the following objective:
- To find out the extent of influence of financial sector development (rural branch
expansion) on poverty reduction and rural employment in India.
1.2 Organization of the Study
The remainder of the paper is structured as follows: Section 2 covers the background of study,
which explains the causes behind rural poverty in India. Section 3 looks into the structure of
Indian banking followed by section 4 which offers an extensive review of the literature on the
banking-poverty-employment linkage. Section 5 presents the methodology and data used for
the study while the section 6 provides the detailed result of the analysis followed by discussion
and conclusion in section 7 and 8 respectively.
5
2. Background of Study
India, with the total area of 3,287,263 square kilometers, is the 7th largest in size and second-
most populous country in the world, with the fastest-growing major economies. India's
population grew from 360 million in 1950 to 1.3 billion in 2016, and India is the world's most
populous democracy. Since the colonial era to date, the region of South Asia has been struggling
with poverty, the 19th century and early 20th century witnessing increasing poverty in India.
Over this era, by reducing garments and other finished products produced by craftsmen in India,
the colonial government de-industrialized India. Due to the surge in industrial development of
the 19th century of Western Europe, they imported these products from the growing sector in
Britain. These colonial policies pushed unemployed artisans into agriculture and turned India
into an increasingly abundant region of soil, unqualified labor, and low productivity. As a result,
India was scarce in skilled labor, capital, and knowledge. Also, Colonial tax policies and their
recognition of land ownership claim from zamindars and mansabdars, or the nobility of the
mughal era, produced a minority of wealthy households (Raychaudhuri, 1982; Roy, 2007).
Furthermore, these policies also weakened the more impoverished farmers capacity to control
land and credit. The resulting increase in landlessness and stagnant real wages aggravated
poverty.
India has been fighting against extreme poverty since then, especially in the rural and remote
areas where sourcing and reach of the established financial institution were always limited.
Several initiatives have been taken by The Government of India to take its own people over the
poverty threshold, but only a few of them saw the light of success. Initially, under British
colonial rule, moneylenders' position was strengthened through the civil court. Nevertheless, in
the early 1900, the moneylenders began to abuse power, taking advantage of the volatile
situation in the country, and taking over farmers' land against their debt (Walker & Ryan, 1990).
6
In a census of 1961, disclosed there were no bank branches in any villages and nearly 50 percent
of the towns of India faced the same fate. To monitor the branch expansion program in 1969,
when the National Credit Council was formed, and they noted few findings: 1. less than one
percent of the village population was served by commercial banks. 2. Agriculture, which
contributes 50 percent of the GDP, mostly gets nothing from the bank. 3. Industry, which
contributes to 15 percent of national income, has 67 credit shares in commercial banks. The
nationalization of banks was an attempt to rectify these imbalances of the system and to sustain
a planned development to reduce the inequalities across states. An ambitious approach was
taken by the Central bank of India to make sure people had more access to financial institution
and saved in banks rather than stowing money under their mattresses. This would reduce
leakages from the flow of income and ensure that the money remained in circulation in the
specific areas of the states where no institutional bank was present from before. This attempt in
the late '70s did have an impact on rural society. Recent monitoring by the World Poverty Clock
has found as much as 44 people are getting out of extreme poverty in India. This is a notable
improvement given in 1968; more than 60 percent of the population was living below the
poverty line in India (Fox, 2002) compares to 22 percent of the population in 2012. Though at
the same time, the total population more than doubled, which accounts for an increasing number
of poor people in society.
2.1. Bank Nationalization
On 19th July 1969, the Indian Central Bank took ownership of 14 major commercial banks
through nationalization. It was the first phase of bank nationalization by the Indian government
with an ordinance, which was called Banking companies'(Acquisition and Transfer of
Undertaking) ordinance. These 14 major private sector banks accounted for 70-80 percent of
the total deposit of the country. Before the first phase of nationalization, the State Bank of India
(SBI) was the only bank that was not privately owned. In 1955 the Imperial Bank of India was
7
nationalized, and it was called the SBI and remained the only bank under the government
ownership till 1969. At present, there are 19 nationalized banks in India.
There were two broad reasons behind the idea of nationalization:
I. Public Trust
II. Social Welfare
From the year of Independence 1947 to 1955, there were 361 private sector banks across the
country which failed on an average, more than 40 banks in a year. The people who saved their
money in the banks, were the sufferer of these failures. This led to the public losing confidence
in the banking system, and it discouraged them from saving money in banks. In the short run
after independence, the economy was not self-sufficient, and the country faced various
constraints, financial being the chief of those. One key technique to raising finance for the
economy was mobilizing the savings of the public in order to make an investment in productive
activities and to gain the economic growth momentum. To regain the trust of the public,
government found a solution in the form of nationalization. The idea behind this was to nurture
the public's trust in government rather than in the private sector banks.
Before nationalization the private commercial banks were catering to the needs of large
industries and businesses. Thus, completely ignoring the agricultural sector of the Indian
economy. In the year 1950, only 2.3 percent of bank loans were channeled to the farmers, and
in the year 1967, it further declined to 2.2 percent — serious negligence of the agricultural and
primary sector by the private banks due to minimal opportunity of profitability. During the post-
independence era, the majority of the Indian population was directly depended on agriculture
for their means of livelihood. In 1969 government motive was to mobilize the 70-80 percentage
of deposit held by the 14 largest commercial banks and to use them to finance the priority sector
(agriculture, farming, small industries, small traders, entrepreneurs). The way to do this was to
focus on opening bank branches in rural and backward areas. With this notion, the government
8
included the priority sector3 into the formal financial segment of the economy. In short, these
were the main objective of bank nationalization.
3. Structure of The Organized Banking Sector in India
Resave Bank of India is the apex monetary institution of India, which is responsible for the
regulation of currency, printing of banknotes, and minting coins. It is also known as the Central
Bank of the country. RBI was initially privately owned, but since nationalization, it is owned
by The Government of India. RBI act at the regulator for the Scheduled banks and Co-operative
banks.
Scheduled Banks in India refer to those banks which have been included in the Second Schedule
of Reserve Bank of India Act, 1934. RBI, in turn, includes only those banks in this Schedule
which satisfy the criteria laid down by the said Act. Part of Scheduled bank are, the commercial
banks which are an integral part of India's financial institution system. In simple term, these
banks are the profit-generating institution which receives the deposit from the public (as
savings) and gives loan to the entrepreneur, business holder, household, etc. the main objective
of these commercial banks is to make a profit through interest rates and commission.
Commercial banks consist of Foreign banks, Regional rural banks, Public & Private sector
banks, State bank of India and its associates and other nationalized banks.
Co-operative Banks’ primary objective is to meet the needs of the rural area and agriculture
finance. Co-operative banks are government sponsored, supported and subsidized financial
agency. They are provided with financial aid from NABARD, Reserve Bank of India, Central
3
Priority Sector includes: (i) Agriculture (ii) Micro, Small and Medium Enterprises (iii) Export Credit (iv)
Education (v) Housing (vi) Social Infrastructure (vii) Renewable Energy (viii) Others
9
and State Government. Co-operative banks function as ‘no profit or loss’ basis. Profit
maximization is not the intended primary goal of such banks.
Reserve Bank of India

Central Bank and Supreme Monetary Authority
Scheduled Bank
Commercial Bank Co-operative Bank
Regional Urban State

Foreign
Rural Co- Co-
Banks
Banks operatives operatives
(40)
(196) (52) (16)
Private
Public Sector
Sector
Banks
Banks
(27)
(30)
State Bank of
Other
India and
Nationalized
Associate
Banks
Banks
(27)
(27)
Figure 1: Structure of Organized Banking Sector of India
Notes: The figure is collected from the website of Reserve Bank of India to define the function of the
Scheduled Bank and its categories.
4. Literature Review
Overview
In 2000, the fight against poverty received a renewed strength with the target of halving the
poverty rates by 2015, as the first objective of the Millennium Development Goals (MDGs).4
by 2015 the fall of poverty was noticeable. In the developing world, the number of people living
in extreme poverty has significantly declined, from 47% in 1990 to 14% in 2015. For the past
4
The United Nations Millennium Declaration, signed in September 2000 commits world leaders to combat
poverty, hunger, disease, illiteracy, environmental degradation, and discrimination against women. (World Health
Organization)
10
few decades, rural banking had an important role to play in poverty reduction. The fact that
most of the poor people are living in rural areas, ensuring the access to financial services for
these people will be one of the main objectives in the battle of eradicating poverty by 20305
(Goal 1 of Sustainable Development Goal). Therefore, with enhanced financial intermediation
and increased access to financial services for the rural poor will raise the general income and
reduce poverty to meet the goal of SDG.
Rural Banking Definition
Financial service in a rural area that is accessible by people of all levels is defined as rural
banking. Rural banking services offer everything that is expected to be present at any physical
bank, "including all saving, lending, financing, and risk-minimizing opportunities and
associated norm and institution in rural areas." (Pearce, Davis, Onumah, and Butterworth,
2004). It is clear from the definition that rural banking services do not exist independently rather
it is policy drive and a part of the larger financial system which is affected by the Central Banks'
policies. In most developing countries, the rural banking sectors are largely disjointed
(Germidis, 1990; Besley, 1994) and regularly fails to satisfy the financial needs of the rural
population. In a financial market, one of the most crucial roles is played by the banking
institutions, which involves direct pooling of market savings and channeling it to investment
opportunities. Thus, mobilizing society's savings to its most productive use for the rural
population (Levine, 1999 and 2005).
Evaluation of financial intermediation through rural banking
Over the past years, the rural banking scenario has changed with time, but the primary focus of
remained unchanged: poverty reduction and economic growth. Between the 1950s to 1970s
5
The Sustainable Development Goals address the global challenges we face, including those related to poverty,
inequality, climate, environmental degradation, prosperity, and peace and justice.
11
financial intermediation in rural areas was traditionally dominated by the government. The
method was established to ease the difficulty surrounding access to finance and banking
facilities, to make life easier for the rural population. The interference level differs from indirect
and direct measures aimed at improving the policy environment and increasing credit facility,
respectively (Yaron and Benjamin, 1997). Relative success in different courtiers encouraged
governments to regulate private banks to provide credit for the agriculture sector at a low-
interest level.
The idea of vicious circle of poverty6 was behind the traditional approach, as effectiveness of
saving mobilization and offering saving facilities in rural areas was under question due the low
saving potential in rural locations (World Bank, 2004), it was believed that the vicious circle
could be broken through injection of external funds into the rural market to raise investment.
Thus, it was established that the government should start focusing on agricultural market and
promote rural development as the farmers are not well off and they should be looked after
through credit facilities and the poor are continuously ignored by the private banks7 - This gave
rise to number of dedicated credit institution focused on agricultural investment for rural
population. There was a lot of support behind the subsidized credit facility scheme (Yaron and
Benjamin, 1997). For example, before 1992, around $15.5 billion in agriculture credit was lent
by the world bank to these programs set by the governments (World Bank, 1993).
Unfortunately, as seen in many cases, these programs had limited access compared to the whole
rural population and contributed very minimally to the growth and productivity, yet it came
with a considerable cost (World Bank, 2004). The respective governments supported rural
6
The vicious circle of poverty is a problem of developing countries when a low level of per capita income does
not allow saving and investment at the level necessary to achieve the minimum rate of economic growth.
7
The ignorance toward the rural entrepreneurs from the private banks practically forced them to seek credit from
moneylenders with higher interest rates.
12
credit programs in developing countries such as Indonesia, Peru, and Malawi, the initiative
failed in the named countries because of the faulty strategies, which did not take into account
geography and other difference and adapt the programs to fit the need of their people.
Additionally, these programs created market distortion, which stalled financial development in
many developing countries (Gonzalez-Vega, 2003).
The drawbacks of the traditional approach to rural banking have led to embracing a different
financial system approach to rural banking in the 1980s (Yaron and Benjamin, 1997). The new
approach was developed to succeed in its goal of poverty reduction through cost-effectiveness.
It emphasizes the creation of enabling legislation and the establishment of appropriate
institutions (Von Pischke, 1996), which includes the elimination of market bias. This new
approach suggests that the government should focus on creating a favorable policy environment
that assists the operational, financial market by avoiding intervention in the direct provision of
rural financial services.
The financial systems approach relies on the assumption that to achieve outreach and
sustainability, institutions must follow the economic principles of financial intermediation.
After the implementation of the new approach, the following issues were being highlighted for
the failure in the past, sectors which were not appropriately regulated, macroeconomics
policies, and the last few major limitations linked to financial intermediation in rural areas. In
the period of 1980s and 1990s number of empirical evidences emphasized the importance of
saving, which as a result, forced key development associations to review their approaches and
stress importance on savings, additional to the credit program (Buchenau, 2003). A number of
policy bias which was hindering the growth of the financial sector were abolished after the
implementation of the financial systems approach. This thriving market encouraged foreign
firms to enter into the domestic financial market for better competition. Moreover, it has
13
strengthened supervisory authorities and cost-effectiveness through improved capital to risk
asset ratio (CRAR) and stricter limitation on lending.
Rural banking, poverty and employment
Better access to financial services can only be assured through a more developed financial
sector; it can impact the poverty outcome directly or indirectly. A direct link means broader
outreach and more access to financial services for the poor, and an indirect link refers to a
positive outcome of poverty through economic development.
A well-organized financial sector can have a direct and positive impact on rural poor if the
financial services can fulfill the demand and reach out to the underprivileged population. This
can be done by ensuring proper access to credit facilities, which will improve poor people’s
ability to invest more in the efficient market. Thus, better credit access will result in more
household spending and improved living. However, it can also have a negative impact; if access
to credit remains limited for the rich society, then it will only enhance the inequality in the
society. Greenwood and Jovanovic (1990) developed their inverted-U shaped theory based on
this assumption. The idea behind the theory is that in the initial stage, rural poor will not have
enough money to be able to manage the cost related to accessing financial institutions and
services, and only the people who can afford it will benefit from the system. This will widen
the income gap between the privileged and underprivileged. However, with economic
development overtime, more deficit spending units will emerge to interact with surplus
spending units through financial intermediation, which in turn will allow the underprivileged
side of the society to afford and access the rural banking sector.
Second, the developing financial sector is increasing competition, in-between the rising number
of financial intermediaries (Beck, Demirgüç-Kunt, Levine, 2007). In developing countries,
14
India included, banking industry asset is typically managed by only a hand full of banks, and
the competition is low in the rural areas. With increased competition, banks will try to extend
the reach and improve their services, which will see an increase in financial mobilization. Third,
a physical presence helps the rural banks to deal with any unfortunate events, such as recovering
overdue loans and managing risks associated with loaning to the underprivileged population.
Lastly, the more extensive and powerful rural banking sector can be immune to any additional
cost and risk while having a positive impact on poverty (Rajan and Zingales, 2001).
Economic growth contributes to the indirect impact on financial development and has a direct
impact on productive employment. By improving governance on financial institutions and
economic conditions, financial intermediaries can accelerate economic growth. (Levin, 2005).
In developing countries, absolute poverty tends to fall with economic growth (Ravallion, 2019),
as a knock-on effect is put in motion: economic growth leads to more job opportunities, more
jobs mean more income and in turn investments, further jobs are created and so on. Also, formal
credit and the development of the rural finance system can have a positive effect on rural wages
and employment as a whole (Binswanger and Khandker, 1992). Thus, it can be said that
financial development contributes to indirect poverty reduction, and it can be a powerful
instrument going forward.
Importance of rural banking for poverty reduction
In the rural financial sector, the role of the rural banks is to encourage saving while promoting
growth and poverty reduction. These intermediaries make sure the savings gathered are directed
towards the investment sector for growth and poverty reduction. There is a robust definite link
between national savings and economic growth (World Bank, 2004). Marinating saving can
protect a household when faced with difficult and unexpected circumstances. It is also easier
15
for a family or a person to get access to credit with a good savings record (Marr and Onumah,
2004).
Nevertheless, the rural communities are not used to the idea of cash deposit and instead are
more comfortable with holding on an asset like lands or livestock, against which they seek
credit from the moneylenders. In this way, it harder to mobilize the financial market and
increase the funds for loans (Pearce, Davis, Onumah, and Butterworth, 2004). This puts
pressure on the people (smalls business entrepreneurs, self-employed farmers) who seek loans
for investment, as they must rely on limited financing or moneylenders who loan out fund with
a high-interest rate. Access to financial services for the rural poor can reduce vulnerability,
since most of the rural population are associated with agricultural activities, which can translate
into highly unstable agricultural income this could destabilize household consumption
(Quartey, Danquah and Iddrisu, 2017). Rural banking ensures smooth consumption for the rural
population whilst allowing to build up assets for a sustainable future.
Rural poor in developing countries face unfavorable transaction terms when it comes to lending
(Zellar and Sharma, 1998). In most cases, it is difficult to comply with the terms, which leads
to a higher rate of non-performing loans in rural areas. Thus, rural poor are risk-averse and
cautious about financing a project. However, proper access to credit funds could encourage
people to take up risks and invest in more profitable businesses. Financial service in Asia and
Africa could also help in strengthening rural education, the standard of living, and other welfare.
From the beginning of rural banking programs till now, it has had many critics for and against.
The failures in different countries who implemented rural banking have taught others how to
modernize the approach and work within the risk associated with it. The evidence indicates that
rural banking has effectively raised the standard of living and reduce poverty in rural areas.
16
Grameen Bank in Bangladesh, Bank for Agricultural and Agricultural Cooperatives (BAAC)
in Thailand, The Village Banks of Indonesia, all of these banks have successful stories on
reducing poverty through rural financial intermediation (Yaron and Benjamin, 1997). Each of
them has accomplished in delivering financial services to millions of rural populations, which
contributed to improving poverty situations.
Banking, poverty and employment (an empirical discussion)
Plenty of evidence can be found on poverty reduction through the relationship of rural banking
and economic growth, which is a prerequisite for an increase in productive employment. Rural
bank development helps economic growth, proven by empirical studies (Goldsmith 1969; King
and Levine, 1993a; Beck, Levine, and Loayza, 2000) and contributes to reducing poverty
(Jalilian and Kirkpatrick, 2001; Jeanneney and Kpodar, 2008; Singh and Huang, 2011). The
effective and operational financial system is essential to achieving sustainable economic growth
(Beck, Demirguc-Kunt, and Levine, 2004). Thus, there is a robust and positive relationship
between financial development and economic growth (King and Levine, 1993b); this finding is
in line with the previous finding.
Additionally, there are studies with evidence linking financial sector development and poverty
reduction. Honohan (2004) estimates a 10-percentage point in the ratio of private credit to GDP
should reduce poverty ratios by 2.5 to 3 percentage points. Here private credit to GDP is
negatively related to any interaction with poverty. Jalilian and Kirkpatrick (2005) examined the
contribution that financial development makes to poverty reduction in developing countries
using panel data for 42 countries. The paper’s empirical results indicate that, up to a threshold
level of economic development, financial sector growth contributed to poverty reduction
through the growth-enhancing effect and found the relationship between financial development
and poverty reduction for rural areas.
17
Jeanneney and Kpodar (2008) argued that stimulating financial growth development helps
reduce poverty indirectly and directly by enabling transactions and allowing the poor to benefit
from financial services. They found an inverse correlation between financial development,
which is measured at the ratio of M3(broad money) to GDP and poverty reduction in selected
developing countries. Perez-Moreno (2011) also found evidence of the inverse relationship
between financial development and poverty for developing countries, by applying a modified
form of traditional Granger causality tests. The researcher came to a conclusion that in the
period of the 1970s–1980s financial development as measured by liquid assets of the financial
system as a share of GDP or by money and quasi money as a percentage of GDP leads to
reasonable reduction in poverty. However, this result did not emerge for the period 1980-1990,
when financial development is measured by the ratio of the value of credits by banks to the
private sector GDP; nevertheless, they seem to be strengthened by exploiting summary
measures of financial development.
Beck, Demirguc-Kunt, and Levine (2004) used a comprehensive sample of 52 countries, with
data from 1960 to 1999, to test the link between financial development and income distribution.
The authors found the development of financial intermediary or banks can lessen income
inequality and at the same time, boost the income of the poor and hence reduce poverty. In 2007
the same authors found around 40% of the long-run impact of financial sector development on
the income growth of the ultra-poor is the result of reductions in income inequality, whereas
60% is due to the impact of financial sector development on total economic growth. Another
paper looked into the effects of financial deepening in poverty reduction (Singh and Huang,
2011). They used a sample of 37 sub-Saharan African countries from 1992 to 2006. The
findings were financial deepening could narrow income inequality and reduce poverty, and that
stronger property rights reinforce these effects. Jeanneney and Kpodar (2008) Investigates how
18
financial development is beneficial to poverty reduction directly through the McKinnon conduit
effect and indirectly through economic growth. The authors use developing countries' data
samples from 1966 to 2000, and the results imply that the poor benefit from the ability of the
banking system to facilitate transactions and provide savings opportunities but to some extent,
fail to benefit from greater availability of credit.
Using time-series data from 1970- 2001, Quartey (2005) examined the linkage between
financial development and poverty reduction in Ghana. He finds no significant relationship and
mentioned the insignificant relationship between financial sector development and poverty
reduction is due to the banking system’s failure in Ghana. The banks have not properly directed
the saving towards the poorer sector of the economy because reasons such as, government
deficit financing, high default rate, lack of collateral and lack of proper business proposals.
Geda, Shimeles, and Zerfu (2006) examined the role of banking and finance in boosting
household welfare by using a household panel data of urban and rural Ethiopia that covers the
period from 1994 - 2000, the empirical results suggest that access to finance is a significant
factor in consumption smoothing and poverty reduction. They were also able to find evidence
of a poverty trap due to liquidity constraint that limits the capacity of the rural households from
consumption smoothing. In Uganda, Musinguzi and Smith (2000) investigate the borrowing
and saving behavior of the rural household. To conclude, the author mentioned the lack of
access to the financial institution for rural households partially limit them from saving.
Moreover, the saving was used in consumptions rather than in beneficial and productive
projects. Also, the borrowing was more notable in urban areas relative to the rural areas. A
research paper from DM Gross (2001), looks into the relationship between financial
intermediation, growth, and employment. She mentioned, the latest empirical findings show
that developments in the financial sector, whether on the saving or lending side, do contribute
to economic growth and employment. Author Pant and Chowdhury (2004) examine the
19
interaction between employment and financial intermediation, and they stated financial
intermediation increases with level formal sector employment and with increased income more
deposit for the financial sector, hence banks depend success of formal sector employment.
In the relationship between the financial sector and poverty reduction, a considerable number
of studies have been undertaken. There are numerous empirical studies on India, but very few
specifically on banking sector development and its effect on poverty and employment in rural
India. Thus, examining the empirical relationship using recent panel data on India would
contribute to deepening the understanding of the effect of banking sector development and its
effects on poverty and employment.
5. Methodology
5.1. Program
On 19th July 1969, the Indian Central Bank took ownership of 14 major commercial banks
through nationalization. It was the first phase of bank nationalization by the Indian government
with an ordinance, which was called Banking companies' (Acquisition and Transfer of
Undertaking) ordinance. (Reserve Bank of India, 4th September 2008). These 14 major private
sector banks accounted for 70-80 percent of the total deposit of the country. Afterward, the
Central Bank came up with the ambitious branch expansion program, with the idea of
expanding the rural banking network to make sure individual access to banks across Indian
states.
This new program pushed the banks to open branches in rural unbanked locations. Banks were
given a list to select from to open branches in unbanked locations for the expansion, circulated
by the Central Bank. The list consisted of all unbanked locations with a population above a
certain number. The same population proportion was applied all over India. The list mostly
20
focused on the location of states which had a lower number of branches per capita. Further,
more locations were targeted in a district with fewer bank branches per capita.8 The list was
updated every three years with a lower population limit.
Before opening a new branch, banks required to obtain a license from the Indian Central Bank
according to the 1949 Bank Regulation Act. In 1977 the Central Bank initiated a new branch
licensing policy to guarantee new branch opening in targeted rural unbanked locations. The
instruction was clear, to obtain a license to open a branch in already banked location, banks
need to open four branches in unbanked locations. The intention of ratio 1:4 was to force the
commercial banks to open branches in already banked locations while at the same time expand
into the new unbanked locations. After 13 years in 1990, the Central Bank of India decided to
discontinue the branch expansion policy and stated branch expansion should only take place if
there are any 'requirement, business potential and financial viability of the location.
(Government of India, 1991). Nevertheless, banks were not allowed to close the existing rural
branch if it is the only one serving the given location.
Along with the expansion into the rural districts, the Central Bank also had to ensure increased
savings and credit opportunities for the rural population. To do so, they regulated the deposit
and lending policies. From 1969 to 1990, the rural rate of credit lending was well below the
urban rate, and the saving rate was higher for the rural areas. The higher savings rate in rural
areas in the periods point to the effectiveness of the program. The Central Bank also ensured
that banks' lending targets are met with respect to the priority sector. The last obligation for
every bank branch was to maintain a credit-deposit ratio of 60 within its geographical area; this
8
One lead commercial bank responsible for monitoring all the branch expansion activities within each district,
assigned by the Central Bank of India.
21
is due to the banks' considerable interest in focusing their lending into the urban areas and
population.
This paper focuses on rural poverty and employment and aims to observe the impact it had due
to the branch expansion program. The branch data set are collected from the Indian Central
Bank (Reserve Bank of India, 2019)9 to examine the extent of branch expansion. This data set
identifies every branch that has been opened since 1961-2015, whether it opened in a rural
banked location (which already has one or more bank branches) or, most importantly, whether
it opened in an unbanked rural location.
5.1.2. Data Description
From the combined branch data, I have created an annual state-level panel for chosen 15 Indian
states (Andhra Pradesh, Assam, Bihar, Haryana, Gujrat, Karnataka, Kerala, Madhya Pradesh,
Maharashtra, Tamil Nadu, Uttar Pradesh, and West Bengal), for the year 1961-2015.10 The
number of bank branches per capita in the state in 1961 is classified as a state's initial financial
development. I took the cumulative numbers of new branches opened in both, rural unbanked
locations, and rural banked locations to measure the rural branch expansion in both types of
areas, respectively. Between 1961-2015, the number of branches opened in rural unbanked
locations in our sample sates increased from 106 to 29600. Eighty percent of this expansion
took place during the above-mentioned branch banking policy years of 1977 to 1990.
From All Rural Credit Survey (1954) data, we see a significant rise in rural household credit
borrowing from commercial banks. Between 1961 and 1991, commercial banks borrowing as
9
Each branch in the dataset is a distinct physical entity (typically a concrete building), which undertakes deposit-
taking and lending activities. It is usually staffed by an officer, two clerks (one of whom is the cashier), and a
security guard.
10
These states cover over 93 percent of the Indian population.
22
a share to total rural debt went from a mere 0.4 percent to 29 percent, and in 2002 it came down
to 24.5 percent. This increase in 1991 came at the expense of borrowing from moneylenders.
Their share fell from 60.9 percent in 1961 to 15.7 percent in 1991, and in 2002 with regained
advantages, they have been able to recoup 29.6 percent of the market share. (Pradhan 2013).
To understand the effect of rural branch expansion, and how it contributed to the credit
mobilization, I examine the data on the shares of commercial bank credit and saving of all
offices to rural branches credit share and saving shares, respectively.
The next focus is on, how rural branch expansion has contributed to rural household welfare,
as I examine the poverty outcomes. During the period, I measured the poverty headcount ratio,
which signifies the proportion of people living under the poverty line. Through the sample
period, the poverty headcount ratio remained 44 percent for rural and 36 percent for urban
locations. Furthermore, I look into rural and urban employment situations from 1990 to 2008
and examine how branch expansion post-1990 effected the labors' and farmers' employment
situation. Through the data, it is also possible to monitor the unemployment situation and its
effect on poverty. Poverty data and employment data are independently collected from separate
government agencies.11
5.2. Identification of Strategy
In this segment, we exhibit that in India, the majority of rural branch expansion was policy-
driven, and in rural areas, banks' credit and saving were increased significantly. The initial
factor allows for a constant evolution of the branch expansion program, and the second indicates
11
Various National Sample Survey (NSS) rounds with employment and unemployment data and household
expenditure survey for poverty measures along with Planning comission reports on methodology and estimation
of poverty, formed by Government of India (2012).
23
we can interpret the results as instructive of the economic impact of the state-led financial
intermediation.12
The licensing policy forced the commercial banks to open more branches in less financially
developed states, rural unbanked locations. It is understandable why financially developed
states would be more attractive for the commercial banks in terms of profitability. Without the
branch licensing 1:4 rule, financially developed states would continue to get the attraction from
the branches, and poorer states would not have seen any developments in the near future. This
suggests that if the introduction of the rule had any imposition in 1977 and after 1990, following
the cancelation, then it should alter the relationship between initial financial development of
states and rural branch expansion within this period.
I used state-level panel of data for the number of bank branches, rural credit and saving shares,
poverty, and employment outcome to find whether the branch expansion program affected rural
poverty. The easiest way to estimate, for an Indian states i and year t, an OLS regression of the
form.
(1) y"# = &" + (# + )*"#+ + ,"#
where y-. denotes the rural headcount ratio, *"#+ is cumulative branch opening in rural unbanked
locations per capita, and &" and (# is state and year fixed effects respectively. An interpretation
of the estimated parameter ), is bit difficult. Without the policy in place for branch placement,
it is expected to have greater branch expansion in richer states. If wealthier states manage to be
more effective on reducing poverty, then ) would be an overestimate of the actual poverty
12
My focus is on the economic impact of bank branches, which avoids many of the endogeneity problems
associated with a direct study of the impact of credit flows. Similarly, Jayarathne and Strahan (1996) use
information on when a U.S. state relaxed branching restriction to examine how economic growth is affected by
financial markets.
24
impact of rural branch expansion. However, if the program is a success and Indian Central Bank
can force the banks to open more branches in poorer states, then according to the above logic,
) would underestimate the actual poverty impact of rural branch expansion.
This complication can be resolved with instruments for rural branch expansion. Perhaps the
implementation and cancelation of the 1:4 branch licensing policy, which linked branch
expansion in unbanked locations to that in already banked locations, can deliver such
instruments. In-between 1977 and 1990 the policy, if effective in getting the desired results,
branch expansion should have been more rapid in financially less developed states since these
states have more unbanked locations altogether. Opposite should be true outside this time
period as locations financially less developed states provides banks with lower profits and thus
less attractive to the banks. These trend reversal from 1977-1990, and then form1990-2005,
and post-2005, is how a state’s initial financial development has affected rural branch expansion
- construct a valid instrument for branch opening in rural unbanked locations if, comparative
to the pre-1977 trend, these trend reversals were significant and had no direct influence on
poverty outcomes. I look into the validity of these assumption in the remainder of the section,
by estimating:
(2) *"#+ = &" + (# + /# × *"1231 + 4# × 5"1231 + ,"#
B-1231 denotes the number of bank branches per capita in state i in 1961, is the measure of initial
financial development. This variable enters the regression interacted with year dummies, with
/. denoting the year-specific coefficients. The difference between /. + 1 and /. tells us how a
state’s initial financial development affected rural branch growth between years t and t +1.
X-1231 denotes a vector of initial state conditions, which contains log real state income per
25
capita, population density, and the number of rural locations per capita, all measured in 1961.
These enter the regression with year-specific coefficients 4. .
Figure 2 graph the /# coefficients from this regression (the reference year is 1961) for two
specifications. The light blue line are the coefficients from a specification without the
5"1231 controls, and the dark blue line are from a specification with the 5"1231 controls, and the
1961 dummy is omitted.13 As already mentioned, from the regression /# summarizes the effect
between state variation in initial financial development on the cumulative number of branches
opened in rural unbanked locations as of year t. As the dependent variable is a cumulative
Figure 2: Initial Financial Development and Rural Branch Expansion (unbanked

locations)
Notes: The series “rural branches in unbanked locations (with controls)” graphs the annual coefficients on
initial financial development (as measured by the number of bank branches per capita in 1961) from a
regression of the form described in equation (2). The series “rural branches in unbanked locations (without
controls)” graphs the annual coefficients implied by the trend break model, column (1), Table (1). In both
cases, the dependent variable is the cumulative number of rural branches opened in unbanked locations.
13
Year 1961 is chosen as it is the census year preceding bank nationalization. The results are robust to choosing
any alternative year as the control year.
26
variable, an analogy of the coefficients for any two adjacent years (/# and /#91 ) is informative
of the relationship between initial financial development and the growth in rural branch
openings.
Throughout the period in every state the trend remained upward for the number of rural banked
locations. Nevertheless, two clear reversal emerges in Figure 2 with the correlation between a
state’s initial financial development and number of rural banked locations, first one in 1977 and
then the second one in 1990. From the data we evaluate between 1961 and 1977 the /#
coefficient increased with time – which interprets to, financially more developed states observe
higher growth of rural banked locations. In this period banks enjoyed substantial flexibility on
where to locate their new branches. For obvious reason banks preferred financially more
developed states as these locations offered superior profit opportunities compare to less
developed states. Afterwards, a reveres has been observed from 1977, exactly when 1:4 branch
licensing policy was imposed, and the reversal is not temporary. In the period of 1977 to 1990
the /# coefficient declined with time – which signify, financially less developed states observed
higher growth of rural banked locations. After 1990 the /# coefficient remained constant, but
we see a very slight increase from 2006 to 2015 – which is not very significant. As per Central
Bank the branch expansion policy of 1:4 ended in 1990. On September 2005 the Central Bank
decided to encourage banks to open new branches in unbanked location, as they asked the new
private sector banks to open at least 25% of their branches in rural and semi-urban areas, which
explains the slight increase in Figure 2 from 2006. Overall, the precise resemblance in the
timing of trend reversal and lack variation of /# after 1990 suggest that the pattern of the rural
branch expansion across India was policy driven.
Additional evidence that no outside factor causes the trend reversals in Figure 2, occurs from
the branch opening data in already banked locations. The licensing rule linked branch expansion
in already banked locations to that in unbanked locations. Banks had the flexibility on deciding
27
where to open a new branch in already banked locations. If the affiliation between initial
financial development and bank profitability remained unchanged during this period, then the
implementation and subsequent cancelation of the 1:4 license rule should have affected the rate
of branch expansion in already banked locations but not its distribution across states. To find
out, I ran the regression (2), where cumulative number of branches opened in banked locations
per capita is the outcome variable. Figure 3 graphs out the /# coefficients on the interaction
between initial financial development of a state *"1231 . This result shows, there have been an
effect of policy change in 1977 and 1990, but the results remained positive otherwise. This
result echoes with results of branch opening in rural unbanked locations in pre-1977 period but
have a firm difference with what was happening between 1977 to 1990, and afterwards a steady
incline till 2005 and then major increase of the /# coefficients up to 2015 - that is, financially
more developed states witness higher growth of rural banked locations.
Figure 3: Initial Financial Development and Rural Branch Expansion (banked locations)
Notes: This series “number of branches in banked location” graph the annual coefficient on initial financial
development (as measured by the number of bank branches per capita in 1961) from regression described in
equation (2). Interaction terms from a regression in which the dependent variable is the number of branches
opened in already banked locations. The regression includes population, income and location controls.
28
The major trend reversal came in-between 1977 to 1990 when branch expansion and financial
mobilization occurs with policy implementation by the Central Bank, other than this period,
only limited variation can be observed in other years (Figure 2). This variation in Figure 2, can
be summarized by a linier trend break model.
(3) *"#+ = &" + (# + /1 (*"1231 × [< − 1961])
+/B (*"1231 × [< − 1977]) + /D (*"1231 × [< − 1990]) + /F (*"1231 × [< − 2005])
+/I (*"1231 × J12KK ) + /3 (*"1231 × J122L ) + /K (*"1231 × JBLLI ) + ,"#
State and year fixed effects account for underlying differences throughout states and national
events which may affect branch expansion. [t - 1961], [t - 1977], [t - 1990], [t – 2005] are linear
time trends, which refers to 1961, 1977, 1990 and 2005, respectively. These enter the regression
related with *"1231 , our measure of a state’s initial financial development. J12KK , J122L and
JBLLI are dummy variables. The important coefficients of interest are /1 , /B , /D OPQ /F which
measure the average trend relationship from 1961 to 1977 between a state’s initial financial
development and rural branch expansion, and the following changes in this trend relationship
(between 1977 and 1990, between 1990 and 2005 and lastly between 2005 and 2015). To check
for trend reversals in this relationship we include three interaction terms /I , /3 OPQ /K — first,
an interaction of *"1231 with dummy variables which equals one post 1976 (P1977) and second
one post 1989 (P1990), then and third an dummy variable which equals one post 2004 (P2005).
Finally, 5"1231 included as the set of additional controls, inputted in the regression in the same
way as *"1231 . With the inclusion of controls, it ensures any observed trend reversals in *"1231
do not proxy for trend breaks in a state’s economic and demographic characteristics (as
measured by 5"1231 ). A typical concern with difference in using panel data in a difference
estimation is serial correlation. Hence, we cluster our standard errors by state in all of the
regressions. This procedure gives us an estimator of the variance-covariance matrix which is
29
consistent in the presence of any correlation pattern within states over time (Bertrand and Duflo,
2004).
Column 1 of Table 1 reports the results. Between 1961 and 1977, one additional point of initial
financial development increased branch openings in rural unbanked locations per capita in a
state by 0.05 annually.
There was a significant trend reversal in 1977 which lines with the pattern observed in Figure
1. Between 1977 and 1990, one additional point of initial financial development reduced annual
branch expansion by 0.19 branches per capita, as financially less developed states observed
higher growth of rural banked locations and location which are financially stronger and more
populated had fewer new branches in an unbanked location. Finally, after 1990 till 2005, a
state’s level of initial financial development and rural branch expansion trend reversed
significantly as one additional point of initial financial development reduced annual branch
expansion to 0 branches per capita, as per the data the branch partially expansion stopped at
that point and afterwards the trend continued and increased by 0.13 branches per capita annually
in a state from 2005 to 2015, an observation which suggests as the commercial banks had the
option to choose where to open their branches in this period they opted to open new branches
in financially more developed states with greater population and business opportunities. These
results after 1990 suggest, rural branch expansion in unbanked locations decreased significantly
as soon as 1:4 branch licensing policy was revoked. The interaction term J12KK has a significant
positive interactive effect, which signals a strong branch expansion growth in unbanked
locations which are financially poorer and less developed.
One of the major ideas behind rural branch expansion program was financial mobilization in
rural areas, thus ensuring rural households’ access to formal sector credit and saving. Figure 4
30
Table 1 – Banking as a Function of Initial Financial Development
Branches
in rural Rural Bank Branches Credit Share
unbanked in banked
locations Credit Share Saving Share locations Priority Sector Cooperative
(1) (2) (3) (4) (5) (6)
Number of bank branches per capita 0.05** 0.04 -0.03 0.14*** -0.89*** 0.37
in 1961*(1961-2015) trend (0.02) (0.24) (0.15) (0.00) (0.15) (0.30)
Number of bank branches per capita -0.24*** -0.90* -0.90** -0.05** 1.20*** 0.07
in 1961*(1977-2015) trend (0.03) (0.50) (0.24) (0.02) (0.22) (0.32)
Number of bank branches per capita 0.19*** 0.74** 0.58** 0.06** -0.48* -1.04***
in 1961*(1990-2015) trend (0.04) (0.34) (0.14) (0.015) (0.25) (0.22)
Number of bank branches per capita 0.013 0.65** 0.39 0.50*** 0.56* 0.63***
in 1961*(2005-2015) trend (0.15) (0.13) (0.24) (1.00) (0.27) (0.06)
0.35** -1.59 -1.13** 0.45*** -5.94** -1.86
Post 1976 dummy *(1977-2015) trend
(0.10) (1.5) (0.44) (0.10) (1.55) (1.32)
-0.22* 1.12 0.34 -0.31** 0.60 -1.68
(0.07) (1.64) (0.65) (0.08) (1.96) (1.07)
0.004 -2.49* 2.52** -1.49*** -2.48 3.27***
(0.04) (1.33) (1.08) (0.21) (4.42) (0.60)
State and year dummies YES YES YES YES YES YES
Other controls YES YES YES YES YES YES
Advance R-squared 0.98 0.92 0.89 0.98 0.86 0.92
20.96 9.68 32.46 21.47 4.11 8.49
F-test 1
(0) (0.01) (0) (0) (0.07) (0.01)
0.01 1.28 6.39 38.32 0.97 39.14
F-test 2
(0.91) (0.28) (0.03) (0) (0.34) (0)
30.26
0.87 39.10 0.06 1.62 0.05
F-test 3 (0)
(0.37) (0.00) (0.81) (0.23) (0.82)
(0)
Observation 660 564 564 660 564 659
Notes: Standard errors clustered by state are reported in parentheses; p-values are in square brackets. F-test
1, F-test 2 and F-test 3 are the joint significance test for coefficients in the first two rows, first three rows and
first four rows, respectively. Rural bank credit (saving) share is the percentage of total bank credit (saving)
accounted for by rural branches. Priority credit share is share of bank lending going to priority sectors.
Cooperative credit share is primary agricultural cooperative credit as a percentage of total cooperative and
bank lending. Explanatory variables reported are bank branches in 1961 per 100,000 persons interacted with
(row-wise) (a) a time trend, (b) a post-1976-time trend, (c) a post-1989-time trend, (d) a post- 2004-time
trend. Other controls include state population density, log state income per capita, and log rural locations per
capita, all measured in 1961. They enter the regression in the same way as branches per capita in 1961. The
Data Appendix describes the data sources and the time period for which each data series is available. *
Significant at 10-percent level. ** Significant at 5-percent level. *** Significant at 1-percent level.
graphs out the estimated /# coefficients from a regression described by equation (2). Where
share of total bank credit accounted for by rural branches is the dependent variable. Similar to
the pattern for rural branches, rural credit share is initially higher in financially more developed
states and then the patterns reversed before 1977. This tells us share of lending accounted for
31
by rural branches is greater in states with lower initial financial development. After 1990 the
relationship remains widely positive with few ups and downs.
Column 2 of Table 1 reports the corresponding results for the linear trend-break model.
Disbursements via rural banks are higher in more financially developed states until around 1976
when there is a trend reversal. Between 1977 and 1990 we see more poorer states experiencing
a greater share of credit being disbursed via rural banks.
Figure 4: Initial Financial Development and Rural Bank Credit Share
Notes: The series “rural credit share” graphs the annual coefficients on initial financial development (as
measured by the number of bank branches per capita in 1961) from a regression of the form described in
equation (2). The dependent variable is the share of total bank credit disbursed by rural bank branches.
Column 2 of Table 1 reports the corresponding results for the linear trend-break model.
Disbursements via rural banks are higher in more financially developed states until around 1976
when there is a trend reversal. Between 1977 and 1990 we see more poorer states experiencing
a greater share of credit being disbursed via rural banks. After 1990 to 2005 the relationship
between rural credit share and initial financial development reverts to being broadly positive
and it stays positive in the next point of initial financial development from 2005 to 2015. From
with a strong negative affect from JBLLI on credit share, and a strong significant JBLLI positive
32
interaction for saving share. From Reserve Bank data of 2002 (Pradhan 2013), we see a strong
growth in moneylenders market share which could explain the negative effect of the dummy
variable on rural bank credit share and positive interaction effect on rural bank saving share as
saving continues to see a constant healthy growth. Other than this a similar pattern exists for
the rural savings share trend analysis in column 3.
The most likely explanation for the negative relationship between credit and saving flows and
initial financial development between mid 1977 and 1990 is the higher growth of rural branches
in financially poorer states. These findings put us on stronger grounds in interpreting the
economic effects of rural banks as improved financial intermediation in rural areas.
To provide with further evidence to support the claim of column 1 to 3 changes/trend reversal
are policy driven, I look into data of branch opening in already banked location. Without the
policy restriction, it is normal for banks to choose a location which may have offered them more
profit opportunities. Between 1961 to 2015 banks were free to choose the location to open a
new branch in a banked location. In Table 1 column 4 it is noticeable that through the sample
period more branch opening took place in more financially developed states due to the profit
factor, thus a regulation was needed to shift banks focus elsewhere. Therefore, in from 1977 to
1990 branch opening in already banked location was lower than usual. This is understandable
as during that specific period banked needed to open four unbanked location branches to open
a new branch in a suitable location, which was not profitable. The year after 1990 to 2015
echoes with Figure 3 as branch expansion in already banked location from 2005 to 2015 trend
is higher than usual and our data set supports the claim.
Move on to column 5 and 6 of Table 1. I look into bank and state level policies, which should
remain unchanged by the 1:4 licensing policy. In column 5, the fraction of bank credit going
to priority sectors (small-scale industries, services, and agriculture). The targets of priority
33
sectors were a requirement for bank level and stayed independent of the states wise allocation
of banks rural and urban branches. In a similar vein in column 6, the fraction of banks total
credit and cooperative credit going into primary agricultural cooperatives, which is controlled
by the state governments. In both cases there are no evidence of trend breaks, this research also
observes state economic, political and policy variables which have the higher probability to
affect the rural poverty, but not similar time trend breaks were seen related to initial financial
development (Burgess and Pande 2005).
The coverage of Indian states to the rural branch expansion program was jointly determined
by its initial financial development and the license regime shifts and observe the changes that
follows. Initial financial development and rural branch expansion were negatively correlated
Between 1977 and 1990, with the reverse true outside this time-period.
6. Basic Results
6.1. Reduced Form Evidence
This section presents the key results starting with reduced form evidence on the relationship
between poverty outcome and states initial financial development. Then it looks into the
instrumental variable evidence of how branch expansion in rural unbanked location affected
poverty outcomes with estimate a regression:
(4) /"# = &" + (# + R# × *"1231 + 4# × 5"1231 + ,"#
Findings from this regression is reported in Figure 5. In the dark blue line, the triangles represent
the R# coefficient when /"# is the rural headcount ratio. Similarly, when the /"# is urban
headcount ratio the square in the gray line represent the R# coefficient.
Both the patterns will tell us about the rise and fall of the poverty in relation to the financial
development of the state. In Figure 5 we see from 1969 to 1982 both rural and urban poverty
34
correlate negatively with the financial development – which is rapid poverty reduction in state
with higher initial financial development. Afterwards till 1992, rural poverty coefficient has a
positive trend which interpret as rural poverty reduction at that time was more notable in the
states with lower initial financial development. For urban poverty R# coefficient stays close to
zero for the maximum time before its fall since 1991, the same pattern is parallel with the rural
poverty series as well, but the correlation takes a slight reverse in 2001 – which again signify
poverty reduction in the locations with lower initial financial development. Thus, the plot for
rural poverty in Figure 5 graph is the inverse of the branch expansion graph (Figure 2).
Figure 5: Initial Financial Development and Poverty
Notes: The series “rural headcount ratio” and “urban headcount ratio” graph the annual coefficients on initial
financial development (as measured by the number of bank branches per capita in 1961) from regressions of
the form described in equation (2). The dependent variables are the rural and urban headcount ratios,
respectively.
Table 2 will help summarize the poverty outcomes and other related findings using the basic
trend break mode (Equation 3). Before 1977 poverty reduction was more rapid in financially
more developed states. In column 1 One-point increase in initial financial development reduced
rural poverty by an additional 0.58 points. However, the trend did reverse between 1977 and
35
1990 – a one-point decrease in financial development reduced rural poverty by an additional
0.12 points. Further, from 1990 to 2005 a point increase in initial financial development reduced
rural poverty by 0.87 points and once again a trend reversal from 2005-2015 reduced rural
poverty by additional 0.20 point. To interpret the data I looked into two different state and the
movement of their headcount ratio as the pattern is very visible in two different states with
different level of financial development, in Madhya Pradesh from 1961-1977 we see an average
annual increase in poverty headcount ratio was 1.8 percentile, contrast to that in Tamil Nadu
had an average annual decrease in poverty headcount ratio of 0.5 percen-
Table 2- Bank Branch Expansion and Poverty: Reduced form Evidence
Headcount ratio Wage

Rural Urban Aggregate Agricultural Factory
(1) (2) (3) (4) (5)
Number of bank branches per capita -0.58** -0.11 -0.52** -0.007 0.001
in 1961*(1961-2015) trend (0.23) (0.17) (0.21) (0.006) (0.01)
Number of bank branches per capita 0.70** -0.08 0.60** -0.009 -0.004
in 1961*(1977-2015) trend (0.28) (0.16) (0.20) (0.009) (0.013)
Number of bank branches per capita -0.99** -0.15 -0.84** 0.048*** -0.016
in 1961*(1990-2015) trend (0.30) (0.26) (0.21) (0.008) (0.014)
Number of bank branches per capita 0.67 -0.38 0.30 -0.06** -0.002
in 1961*(2005-2015) trend (0.41) (0.46) (0.41) (0.019) (0.02)
-2.57 -3.63** -2.93 0.10** 0.06
(2.19) (1.56) (1.73) (0.04) (0.04)
3.40 -0.25 1.98 -0.01 0.04
(1.95) (1.05) (1.45) (0.04) (0.06)
3.19** 0.61 4.84 -0.02 -0.14*
(1.45) (1.39) (2.85) (0.06) (0.07)
State and year dummies YES YES YES YES YES
Other controls YES YES YES YES YES
Advance R-squared 0.91 0.95 0.93 0.95 0.87
0.23 2.45 0.20 15.41 0.50
F-test 1
[0.64] [0.14] [0.66] [0.002] (0.50)
24.87 4.39 39.45 41.79 1.83
F-test 2
[0] [0.06] [0.00] [0] (0.20)
0.51 4.27 1.72 2.42 3.65
F-test 3
[0.49] [0.06] [0.22] [0.15] (0.08)
Observation 630 627 627 653 658
Notes: Standard errors clustered by state are in parentheses; p-values are in square brackets. Headcount ratio
is the percentage population with expenditure below the poverty line. Agricultural wage is log real male daily
agricultural wage, and factory wage is log real remunerations per worker in registered manufacturing. The
definitions of explanatory variables, other controls, and F-tests for columns (1) to (5) are in the notes to Table
1. The Data Appendix describes the data sources and the time period for which each data series is available.
* Significant at 10-percent level. ** Significant at 5-percent level. *** Significant at 1-percent level.
36
-tile. From 1977 to 1990 the reduction of average annual poverty headcount in Madhya Pradesh
was 0.2 percentile higher than Tamil Nadu. Since 1990 to 2005 Tamil Nadu had significant
reduction in average annual poverty, which on the other hand remain 1.71 percentile lower for
Madhya Pradesh. These results strongly suggest that more rapid expansion of rural bank
branches into more financially poorer states during the 1977-1990 and 2005-2015 period is
affecting poverty reduction in these states relative to more financially developed states outside
this period.
Consistent with the idea that we are assessing the rural program, it is observable in column 2
that initial financial development and urban poverty reduction is not significant and unrelated.
The outcome of column 1 and 2 shows that the gap between rural and urban poverty mirrors
the gap in poverty for rural states. Before 1977 and after 1990 to 2005 the gap closed between
rural and urban poverty in more financially developed states and reverse were true post 1977 to
1990 and post 2005 to 2015. For aggregate poverty in column 3 the results mirror the rural
poverty in column 1. This tells that changes in rural poverty drive the aggerate pattern.
For column 5 it is observable that between 1977 and 1990 agricultural wages increased in less
financially developed states, which accounts for the poorest group of people of the rural area.
The opposite is true afterwards, but a change is also observable from 2005-2015, which
indicates increase in wage in poorer states once more. In column 6, the factory wage which is
mostly located in urban areas shows no relationship with the initial financial development and
do not exhibit any trend breaks.
6.2. Instrumental Variable Evidence
The OLS estimation for new branch opening in rural unbanked areas on rural headcount ratio
is shown in Table 3 Column 1 (the relationship between rural bank branch expansion and rural
37
poverty equation 1). The coefficient on the number of branches opened in rural unbanked
locations is positive and significant.
This positive relationship continues but it appears to be statistically insignificant, once the
interactions between states financial development, time trend and the vector of state initial
conditions as additional covariates are included, Column 2. 14 These results from OLS suggest
that expansion of rural branch increased poverty. However, this is consistent with the program-
based explanation, where the OLS estimate reflects the fact that poorer, financially less
developed states attracted more rural branches between 1977 and 1990.
Furthermore, I use deviation as instrument in the trend relationship to account for endogenous
branch placement between initial financial development and rural branch expansion which were
prompted by license policy shift in 1977 and 1990 for branch opening in rural unbanked
locations. This is similar to a difference in difference estimator, here the control is for the
systematic variation in branch expansion throughout the states and time including with state
and year fixed effects and a time trend interaction with initial financial development, and only
evaluate the interaction between initial financial development and whether a state is in a
treatment or control period as exogenous. The first stage regression is as in column 1 Table 1,
and the second stage regression takes the form of:
(5) y"# = &" + (# + )*"#+ + S1 ([< − 1961] × *"1231 )
+SB (J12KK × *"1231 )
+SD (J122L × *"1231 )
+SF (JBLLI × *"1231 ) + T"#
14
The coefficient on initial financial development time trend interaction term shows that rural poverty was
throughout lower in more financially developed states.
38
where ([< − 1961] × *"1231 ), is characterized as ([< − 1977] × *"1231 ), ([< − 1990] ×
*"1231 ) and ([< − 2005] × *"1231 ), are the instruments for *"#+ . This strategy assumes that the
instruments affect rural development only via their effect on rural branch expansion.
In Table 3 column 3 – 5 reports IV estimated for poverty outcomes. A point estimate on rural
branches in column 3 imply one additional opening of bank branch per 100,000 person lowers
poverty by 3 percent. Estimated with the sample average our outcomes indicates that India’s
rural branch expansion can explain 28 percent reduction in the headcount ratio. This outcome
line up with the reduce form evidence but it is exact opposite of the OLS results. Column 4
results are unrelated as there is no evidence that rural branch expansion affected urban poverty.
This gives an assurance in that the method is correctly identifying the poverty impact of rural
banking locations.
Also, the downward trend of the rural and urban poverty and given our explanatory variable is
cumulative stock, this result eases any concern of capturing a trend effect. Column 5
summarizes the overall poverty impact of the rural branch expansion program. Opening a bank
branch in one additional rural location per 100,000 persons reduce aggregate head count ratio
by 2.74 percentage points.
From column 6 to 9 I examine if the results for the rural headcount ratio are robust to alternative
specifications by using single control at the beginning. In column 6 the sample is restricted to
pretreatment (1961-1976) and treatment period (1977-1990) and use a single instrument -
J12KK × (< − 1977) × *"1231 . For the next column 7, the restricted treatment period and post-
treatment periods (1977-2005). Hence, the instrument is- J122L × (< − 1990) × *"1231 . For
column 8 I, instead, restrict the sample to the treatment and post-treatment periods (1990-2015)
with the instrument - JBLLI × (< − 2005) × *"1231 . In first two cases rural branch opening did
reduce rural poverty headcount ratio, and the magnitude is much
39
Table 3 – Bank Branch Expansion and Poverty: Instrumental Variable Evidence
Headcount ratio Wage

Rural Urban Aggregate Rural Agriculture Factory
1961-1989 1977-2005 1990-2015
OLS IV IV IV IV IV IV IV IV
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
Number of branches opened in rural 3.19** 1.50 -3.00** 0.014 -2.74** -2.86** -4.74** 16.87 0.06 -0.01
unbanked locations per capita (0.95) (1.61) (1.14) (0.54) (0.82) (1.14) (2.41) (16.60) (0.03) (0.04)
Number of bank branches per capita -0.48** -0.56** -0.24*** -0.52** -0.43 -0.80*** -0.89*** 0.002 -0.010**
in 1961*(1961-2015) trend (0.12) (0.16) (0.05) (0.15) (0.27) (0.16) (0.19) (0.003) (0.004)
1.81 0.24 -2.24* -0.27 -1.54 -0.05 0.18**
(2.11) (2.18) (1.10) (1.94) (1.89) (0.04) (0.08)
5.93* 0.80 -0.75* -0.10 1.86 0.20*** -0.02
(2.78) (1.51) (0.46) (1.07) (1.64) (0.03) (0.05)
1.69 3.06 -2.16* 3.69 4.94* 0.015 -0.27***
(2.82) (3.09) (1.52) (3.90) (2.48) (0.08) (0.05)
State and year dummies YES YES YES YES YES YES YES YES YES YES
Other controls NO YES YES YES YES YES YES YES YES YES
Overidentification test [0.99] [0.99] [0.99] (0.99) (0.99)
Adjusted R-squared 0.86 0.91 0.89 0.95 0.92 0.80 0.88 0.90 0.93 0.87
Observations 786 630 630 627 627 348 348 282 653 658
Notes: Standard errors clustered by state are in parentheses; p-values are in square brackets. The definitions of the dependent and explanatory variables are in the notes to
Table 2 and Table 1, respectively. In the IV regressions, the instruments are the number of bank branches per capita in 1961 interacted with (a) a post-1976-time trend, (b)
a post-1989-time trend and (c) a post-2004 time trend, respectively. Table 1, column (1), reports the corresponding first-stage regression. In the second row of columns 6
and 7, the number of bank branches per capita is interacted, respectively, with a (1961–1989), (1977–2005) and a (1990-2015) trend. The overidentification test is employed
is due to John Denis Sargan (1958). The number of observations times the R-squared from the regression of the stage-two residuals on the instruments is distributed chi-
squared (T + 1) where T is the number of instruments. The Data Appendix describes the data sources and the time period for which each data series is available. * Significant
at 10-percent level. ** Significant at 5-percent level. *** Significant at 1-percent level.
40
larger in the second case. A likely interpretation is financial liberalization has affected
independently on rural poverty during the control period (1990-2005). In column 8 with the
control period of (2005-2015) the results show rural branch expansion didn’t contribute to
poverty reduction rather the result provides us with an insignificant increased poverty outcome
for this period.
Lastly, I look into the operations of agriculture labor- an alternative measure of household
welfare. One of the largest and poorest occupation group compromise agriculture laborers.
Range of studies on poverty suggest agricultural wage constitute an important independent
market of rural welfare (Dreze and Mukherjee, 1991; Deaton and Dreze, 2002). In column 9
and (10) on agricultural and factory wage, it shows rural branch expansion has next to no effect
on agricultural wages and factory wages. The trend in column 10 row 2 regression suggest that
rural factory wage reduced with the branch expansion. Though the nonagricultural economy is
flourishing rural India (DN Reddy, A Reddy, Nagaraj and Bantilan 2014) but in recent time
rural labor wage have seen a fall, specially the manufacture side of rural industry. This is due
to more supply of rural labor than demand. As mentioned by the authors Chand, Srivastava and
Singh, in 2017 the impressive growth of nonagricultural sector in rural India has not brought
significant employment gains.
In Table 1, in 1977 rural credit and saving share exhibited a trend reversal in the relationship
with initial financial development. This suggest it is possible to replicate the IV procedure,
measuring financial intermediation with rural credit and saving share. In Table 4 column 1 to
(4) conveys that increase in rural credit disbursement and saving share reduces rural poverty.
An increase of one percentage point in credit share disbursement by rural branches reduces
rural poverty by 0.65 percentage point (column 1), likewise one percentage point increase in
rural saving reduces poverty by 0.89 percentage point (column 2). In column (3) and (4) urban
41
poverty also reduces significantly due to rural credit and saving mobilization. Lastly in column
5 and 6 tells, increase in rural credit and shavings reduces the aggregate poverty of India.
Table 4 – Rural Credit and Savings and Poverty: Instrumental Variable Evidence
Headcount ratio
Rural Urban Aggregate
(1) (2) (3) (4) (5) (6)
-0.65* -0.36* -0.71**
Rural bank credit share
(0.35) (0.19) (0.31)
-0.89** -0.48** -0.88**
Rural bank savings share
(0.39) (0.17) (0.29)
Number of bank branches per capita -0.69*** -0.93*** -0.47*** -0.60*** -0.69*** -0.90***
in 1961*(1961-2015) trend (0.13) (0.19) (0.10) (0.11) (0.11) (0.16)
-1.88 -1.44 -3.33** -3.09** -2.70** -1.99
(1.74) (1.73) (1.15) (1.18) (1.44) (1.49)
3.52* 2.87 0.67 0.29 2.45 1.81
(2.05) (1.71) (1.22) (0.76) (1.79) (1.23)
3.65* 7.23** 0.04 1.99 4.68 8.10**
(2.02) (2.52) (1.43) (1.63) (2.82) (3.39)
Overidentification test [0.99] [0.99] [0.99] [0.99] [0.99] [0.99]
Adjusted R-squared 0.90 0.89 0.95 0.95 0.92 0.91
Observations 534 534 531 531 531 531
Notes: Standard errors clustered by state are in parentheses; p-values are in square brackets. The definitions
of the dependent and explanatory variables are in the notes to Table 2 and Table 1, respectively. The notes
to Table 3 describe the instruments and the overidentification test. Table 1, columns (2) and (3), report the
first-stage regressions for rural banks credit and savings share, respectively. The Data Appendix describes
the data sources and the time period for which each data series is available. * Significant at 10-percent level.
** Significant at 5-percent level. *** Significant at 1-percent level.
Table 5 checks the time-varying political and policy variable in steering rural India’s poverty
reduction. In column 1 is included with two state wise expenditure measure – spending on
health and education and other development sending which consist of agricultural spending,
rural development, irrigation, public works and community development program. These types
of spending are equally important for states poverty reduction efforts. Parallel to other studies
findings, it can be seen that development spending reduces rural poverty (Besley and Burgess,
2000). Moreover, the relationship between rural branch expansion and rural poverty continues
to be negative and significant. In column 2, I use control for political make-up of state
legislatures. Political parties in India normally vary in respect to both their commitment to
42
redistribution and the people or groups in favor they redistribute for. In my findings, it is
noticeable that other than the Congress parties and Regional parties none of them have effect
on poverty outcome. This could be because in-between the time period (1961-2015) this one
political party was elected most times to run the government; thus, the result outcome is
significant. Also, to notice, with full set of additional controls included the influence of rural
banks on rural poverty remains robust. Finally, in column 3 and 4 I implement the same method
for urban headcount ratio and find no impact of rural bank branches, development spending or
political composition on urban poverty.
Table 5 – Bank Branch Expansion and Poverty Reduction: Robustness Checks
Rural headcount ratio Urban headcount ratio

(1) (2) (3) (4)
Number of branches opened in rural -3.55** -2.55** -0.03 0.21
unbanked locations per capita (1.21) (0.74) (0.57) (0.65)
Health and education spending -5.90 -7.48 -0.63 -2.45
(12.94) (5.53) (6.02) (6.22)
Other development spending -21.98* -20.60** -0.21 0.78

(11.04) (9.53) (0.05) (4.17)
Fraction legislators from:
-11.11** 1.40
Comgress parties
(5.02) (2.18)
-8.50 0.37
Janata parties
(6.02) (1.85)
0.95 -3.40
Hindu parties
(5.37) (3.76)
-8.62 -7.47
Hand left parties
(9.40) (6.90)
-18.96** -0.15
Regional parties
(6.75) (3.23)
State and year dummies YES YES YES YES
Other controls YES YES YES YES
Overidentification test [0.99] [0.99] [0.99] [0.99]
Adjusted R-squared 0.89 0.91 0.95 0.95
Observations 626 625 623 622
Notes: Standard errors clustered by state are in parentheses; p-values are in square brackets. The definitions
of the dependent and bank variables are in the notes to Table 2 and Table 1, respectively. Health and education
spending are the fraction of total state spending on health and education. Other development spending is the
fraction of total state spending on agriculture, rural development, irrigation, public works, and community
development programs. Fraction Congress, Janata, Hindu, Hard Left, and Regional refer to number of seats
held in state legislatures by parties in these political groupings. The overidentification test is employed is due
to John Denis Sargan (1958). The number of observations times the R-squared from the regression of the
stage-two residuals on the instruments is distributed chi-squared (T + 1) where T is the number of
instruments. The Data Appendix describes the data sources and the time period for which each data series is
available. * Significant at 10-percent level. ** Significant at 5-percent level. *** Significant at 1-percent
level.
43
In Table 6, I look into the data for relation between branch bank expansion and employment.
Here we observed employment data in comparison with rural branch expansion from 1990-
200815. This stage of the regression takes the form:
(6) !"#$ = %" + '# + (# × !"+,,- + .# × /"+,,- + 0"#
Here, B2+,,- denotes the number of bank branches per capita in state i in 1990, is the measure
of initial financial development. This variable enters the regression interacted with year
dummies, with (3 denoting the year-specific coefficients. The difference between (3 + 1 and (3
tells us how a state’s initial financial development affected rural branch growth between years
t and t +1. X2+,,- denotes a vector of control variables. These enter the regression with year-
specific coefficients .3 .
Table 6 – Bank Branch Expansion and Employment
Rural Employment Urban Employment

Self Paid Unemployed Self Paid Unemployed
(1) (2) (3) (4) (5) (6)
Number of branches opened in rural 1.77 4.13 -0.32 0.86 2.89 -0.08
unbanked location per capita (2.68) (2.97) (0.65) (1.58) (2.17) (0.22)
Number of bank branches per capita -0.06** 0.05 -0.003 -0.001 0.04** 0.005
in 1990*(1990-2008) trend (0.02) (0.03) (0.004) (0.009) (0.014) (0.001)
Adjusted R-squared 0.92 0.72 0.85 0.92 0.95 0.8
Observations 285 285 285 285 285 285
Notes: Standard errors clustered by state are in parentheses; p-values are in square brackets. The rural and urban
employment describes the relationship and effect of rural branch expansion. For column (1)-(6), the yearly sample
survey data is of 1000 people of each 15 states. The Data Appendix describes the data sources and the time period
for which each data series is available. * Significant at 10-percent level. ** Significant at 5-percent level. ***
Significant at 1-percent level.
15
All data from National Sample Survey (NSS). Due to lack for data, I decided to observe the employment
condition starting from the same year when the branch bank licensing policy was revoked.
44
This paper separated the employment situation in three variables for rural and urban states, in
both cases the outcome is not significant. First one is self-employment (which is, self-employed
in agriculture or other household activities like farming), second one as paid-employee (which
is, regular worker and casual labor on wage, working in agriculture or non-agricultural sector)
and last variable for the unemployed population. In column 1, rural branch expansion has
contributed in 1.77 percentage point increase in self-employment. Follows with a negative
significant trend which tells us, rural branch banking expansion increased rural self-
employment in this period. In column 2, branch expansion has increased paid activity by 4.13.
percentage which supports the claim from Binswanger and Khandker, 1992 that India’s’ rural
bank expansion led to nonfarm employment growth and for column 3, expansion didn’t
contribute in employment situation, rather it got worse. For urban employment the results are
not related with rural branch expansion.
In Table 7, This paper used time-varying employment variable with controls to see how the
employment situation is affecting in reduction of rural poverty. Column 1 describes, number of
branches opened in rural unbanked location have contributed in 2.47-point percentage in
reduction in rural headcount ratio. Further, rural self-employment (agriculture and farming) has
a significant impact on poverty reduction. Which supports the cross-country evidence that
agriculture is significantly important in reducing poverty among the poor (Christiaensen,
Demery and Kuhl, 2011). Author JanVry, Sadoulet and Manaswini stated, the power of
agriculture comes not only from its direct poverty reduction effect but also from its potentially
strong growth linkage effects on the rest of the economy. In the next row rural paid employment
doesn’t have an effect on rural poverty reduction according to the collected data, but the
increase of unemployment rate in rural areas does have a significant effect on rural head count
ratio, where it can be seen that poverty headcount ratio increases with the unemployment rate
for the mentioned period. Thus, from evidence it can be said that unemployment increases the
45
risk of poverty (Saunders 2002). The urban employment situation in respect to self-
employment, paid activity or unemployment in column 2 is not significant or related to rural
bank branch expansion program.
The result shows the branch expansion program mobilized the financial wheel of the rural
locations with increased deposit and credit disbursement, in turn reducing poverty significantly
and increased employment opportunities. At the same time, this branch expansion program did
not affect urban poverty in any way or form.
Table 7 – Bank Branch Expansion, Employment and Poverty: Robustness Checks
Rural Headcount ratio Urban Headcount Ratio

(1) (2)
Number of branches opened in rural -2.47 4.81
unbanked locations per capita (8.75) (7.03)
-0.32*
Self Employed rural area
(0.20)
0.012
Paid Emploment rural area
(0.12)
2.91**
Unemployment rural area
(0.95)
0.29
Self Emplyed urban area
(0.52)
-0.19
Paid Employment urban area
(0.32)
2.38
Unemployment urban area
(1.50)
State and year dummies YES YES
Other controls YES YES
Adjusted R-squared 0.86 0.84
Observations 285 285
Notes: Standard errors clustered by state are in parentheses; p-values are in square brackets. The rural and
urban employment and branch expansion describes the relationship with poverty headcount ratio. For column
(1) and (2), the yearly sample survey data is of 1000 people of each 15 states. The Data Appendix describes
the data sources and the time period for which each data series is available. * Significant at 10-percent level.
** Significant at 5-percent level. *** Significant at 1-percent level.
46
7. Discussion
7.1. Rural Branch Expansion (success and limitations)
The primary question in any literature of finance and development is whether a certain
intervention can be identified, which is cable of poverty reduction and helping in economic
growth. There exists a concordable number of cross-country literatures on finance and
development, and a vast amount of empirical and case study which suggests improvement of
the credit market and financial mobilization can lead to economic growth and development.
Nevertheless, it remains a puzzling issue of, whether, when, and how to intervene. The
government-led branch expansion programs have been crucial in increasing access to financial
services in developing countries since the 1950s. Even though these programs have been
successful in some states, still these programs are hardly valued and often criticized. One of the
arguments is that the affluent side of society influenced the outcome of these programs. This
led to the replacement of banks with microfinance institutions.
In this paper, using the data to look into India’s 1:4 licensing policy, the main findings suggest
the program significantly reduced poverty, and at the same time, it did not have any effect on
urban poverty. Over the sample period, poverty in rural India was at its highest in 1968, with
64 percent population living below the poverty line, and in 2015, it fell to 22 percent. Evaluated
at the sample mean, the coefficients in Table 3 estimates more than half of the poverty reduction
can be explained through branch expansion. This result does tell us that ensuring access to
financial services can reduce poverty significantly. However, there have been other state-led
programs underway in the same areas around the same time. One such initiative was anti-
poverty program is Integrated Rural Development Program (IRDP), which was implemented
in 1980 with a strategy of increasing subsidized credit and develop a skill set in the families
living below the poverty line (Kochar, 2018). This suggests that the branch expansion program
47
may not have been the only contributor to the rural poverty reduction in India but an essential
mechanism for attacking poverty.
The branch expansion program abolished in 1990 due to the loss that the commercial banks
were accumulating. The primary reasons behind this were the non-performing loans and high
default rates. In 1980 the average default rate for the commercial banks was a staggering 42
percent (share of all loans due for repayment). For banks, the emphasis was on providing more
credit to meet the target (because of a volume-focused incentive system) rather than paying
equal attention on retrieving the loan. Another reason worth mentioning was a considerable
number of default loans were regularly politically forgiven (Reserve Bank of India, 1997).
Rural interest rates were subsidized, which is one more reason for high program costs. In the
1980s, the average rural bank interest for loans was 11 percent compared to 14 percent of urban
branches, which later rose to about 12.5 average against the 15 percent for urban branches in
1989.
At first sight it may look as though rural branch expansion program in India ended up being a
costly arrangement to mobilize finance in rural low-income areas with no upsides. However, it
is not the policy that caused the disturbance rather than the shortcoming in the implementation
of it. It is well-known that, in the presence of informational irregularities, it may be best for a
government that wishes to target resources to particular groups of citizens to undertake costly
redistribution to best screen amongst citizens (Besley and Coate, 1992). It is well defined that
the Indian Central Bank wanted to use the branch expansion program to redistribute resources
to the rural poor. So, the crucial question is, whether the branch expansion program was the
most cost-effective compared to other costly redistributive programs.
There has been a common consensus that microfinance operations should replace the banks in
rural locations because operating banks are costly and ineffective, whereas microfinance
48
operations are more feasible. This is correct for low income developing countries and India
post-1990 (Morduch, 1999).16 Absence of data for microfinance in India around the same
period of branch expansion program and even afterward make the comparison impossible
though it is possible to look into the branch cost figures of the program carried out by the
Central Bank of India. In 1986, for every 100 rupees in average branch received 11.5 rupees as
loan interest and paid 7.3 rupees in deposit and had other variable costs of 4.8 (Reserve Bank,
1989). Thus, the branches were making a loss of 0.6 rupees per 100 rupees of working funds.
Moreover, due to the default rate, the revenue position was at its worse, with only 58 percent
of loans were repaid, which increase the loss to 5.4 rupees per 100 rupees. This evaluation
clearly put the continuation of rural bank program at risk and by 1990, and hence the Central
Bank decides to abolish the policy. Though it can be seen from the data point view, that rural
branch expansion did take place later as well, but not due to a policy but rather based on an
influx of demand. From the period of 1995-2005, Central Bank decided to leave it to the
judgment of individual banks to evaluate the need for more branches, considering the factors
such as business prospective and financial feasibility.
7.1.2. Further Attempts of Financial Inclusion
Nationalization of 14 commercial banks shifted the model of banking in India, changing the
focus from class banking to mass banking. The idea was always to reach the poor people
through the regional rural banks. The banking sector observed remarkable volume growth over
the year. Although, with substantial improvement in areas relating to financial mobilization and
poverty reduction since the 1990s, there were a distress that banks have failed to include vast
segment of the rural population, especially from the underprivileged part of the society, into the
16
The Indian Reserve Bank task force on microfinance (1997) stated, ‘To achieve a process of change leading to
empowerment of 7.5 million poor households, and more particularly of the women from these households, through
strong and viable people’s structures like Self-help groups and microfinance institutions which draw strength and
support from the banking system with the message that banking with the poor is a profitable business opportunity
for both the poor and the banks’.
49
financial banking services. The formal financial credit system was not being able to effectively
infiltrate the informal financial market. Nationally and internationally, efforts were made to
look into the matter and study the reason for financial exclusion, to ensure strategies to include
the poor and underprivileged into the formal financial system.
One concern for the Central Bank regarding the program was the vast segment of the population
was left excluded by the banks due to their profit maximizing practice. It was necessary to bring
these people into the formal financial sector so that they can have the basic services and grow
their business. It was in this perspective that in the annual policy statement for the year 2005-
06, the Central Bank indicated that there were legitimate concerns with respect to the banking
practices that tended to exclude rather than attract vast segments of the rural population, namely
senior citizen, self-employed and those employed in the informal sector. The policy noted that
while profit generation were no doubt important, banks were given several privileges, and
therefore, they need to provide rural banking services to all segments of the population, on an
equal basis. Against this background, the policy declared that the Central Bank would
implement policies to support the banks, which provided extensive services while deterrent
those which were not active to the banking needs of the underprivileged. One thing notable and
common in every bank was the minimum requirement charges to open a new account for public.
Though, opening a new account would offer few free facilities and services yet the account
opening fees/ minimum balance were discouraging the underprivileged section who opted not
to open an account.
In 2005, Central Bank of India came up with the idea of ‘no-frills’ account which can be opened
with zero balance as well as low future charges on account to make financial market more
accessible for the rural population. Hence the banks were asked to make the necessary changes
and implement the idea. In two years’, time, by the end of 2007, there were significant progress
with 12.6 million new ‘no-frills’ account. Further down the line the in 2012 ‘no-frills’ account
50
were modified to ‘Basic Saving Bank Deposit Account’ with necessary additions of more
facilities (in addition to zero balance, ATM services, free cheque book etc. were added) to
ensure financial inclusion of the poor segment of the population.
Moreover, recently in 2017 the Central Bank of India decided to revisit the idea of rural branch
expansion in a new set of guidelines. The Central Bank stated banks have to open at least 25%
of their outlet in a year in rural unbanked location. Central Bank also clarified, ATM kiosk,
cash deposit center and mobile banking will not be considered as an outlet.17 Till date, this has
been an ongoing process.
8. Conclusion
The results show that the rural branch expansion program contributed to reducing poverty and
increasing employment opportunities. In 1998 India accounted for a third of the people in the
developing world living below the dollar a day poverty line compared to one-fifth of the
population in 2012 living below 1.25 dollars (new poverty line). The improvement is visible,
but along with rural banking efforts the growing micro finance operations also deserves credit
for this. From the study it is clear that external pressure is needed to ensure financial
mobilization in backward rural areas to influence and direct banks towards lending credit to a
poorer individual whilst obtaining and utilizing the savings. However, the overall
accomplishment of the program, rural branch expansion, in reducing poverty for the period of
1961-2015 had positive effects. A key finding of this paper is that it also led to remarkable
improvements in the rural employment sector from 1990-2008.
Developing financial access for the rural underprivileged can have a significant impact on the
livelihood of individuals and well-being of the society. In recent years after launching of several
17
According to the Central Bank, ‘Banking outlet is a fixed-point service delivery unit manned by either
bank staff or its business correspondents where services of acceptance of deposit encashment of cheques
withdraw or lending of money is provided.
51
new initiative related to rural banking the government of India claims to have more people
involved in banking and financial sector. It is claimed almost 80% of the population have bank
accounts and financial access. However, the important question still remains, that how many of
them is actually using the facilities. The growth in financial sector is visible but at the same
time the rural Indian farmers are still seeking credit from the ubiquitous, ravenous loan sharks
- the moneylenders. They have monopolized rural Indian credit market for generations and
continues to be ever present and growing. This shows, maybe along with financial inclusion a
more hand on approach is required to have a better monitoring system. Only then can we hope
for a sustainable rural economic growth and a poverty free rural India.
52
9. Data Appendix
The data used in the paper come from a wide selection of sources.18 The data cover the fifteen
main Indian states, and unless mentioned otherwise the period 1961-2015.19 Haryana enters our
sample in 1965 before it was part of Punjab.
Deflators and Population Deflators used are the Consumer Price Index for Agricultural
Laborers (CPIAL) and Consumer Price Index for Industrial Workers (CPIIW) (reference period
October 1973–March 1974) from Ozler etal. (1996) and have been extended to 2015.
Population and rural location data are from decennial Indian censuses 1961–2015 (Census of
India, Registrar General). Rural locations are defined as towns with fewer than 10,000 persons
and villages with between 2,000 and 10,000 persons.
Banking data refers to scheduled commercial banks.20 The bank branch data is from Reserve
Bank of India [2019] which uses the census definition of rural locations. The initial financial
development of a state is the number of bank branches in that state in 1961 per 10,000
population. A location is categorized as banked if it has at least one branch of any commercial
or cooperative bank. Two bank branch variables are defined: the number of branches opened in
rural locations with no prior presence of commercial banks (rural unbanked locations), and the
number of branches opened in already banked locations. Rural credit share is the proportion of
total advances outstanding of commercial banks which are disbursed by rural branches. Rural
saving share is similarly defined. Share of priority sector lending is the fraction of bank credit
going to the priority sectors. These variables are available from 1969- 2000. Cooperative
lending share is the fraction of total bank and cooperative credit which is accounted for by
18
The data-set builds on Reserve Bank of India for all Bank related, data (1961-2015). National Survey Round for
employment data (1990-2008) and Planning Commission, Government of India and Bugess and Pande [2005]
which collects published data on poverty.
19
The states are: Andhra Pradesh, Assam, Bihar, Gujarat, Haryana, Karnataka, Kerala, Madhya Pradesh,
Maharashtra, Orissa, Punjab, Rajasthan, Tamil Nadu, Uttar Pradesh and West Bengal
20
It includes branch information on five types of commercial banks: (1) State Bank of India and its associates, (2)
nationalized banks, (3) regional rural banks, (4) private sector banks, and (5) foreign banks
53
primary agricultural cooperatives. Data on bank credit and saving is from the Reserve Bank of
India publication Statistical Tables Relating to Banks in India.
Poverty figures are for rural and urban areas of India’s 15 major states. 1961-2000 figures were
put together by Ozler, Datt and Ravallion [1996]. These measures are based on 33 rounds of
the National Sample Survey (NSS) which span this period. The NSS rounds are also not evenly
spaced: the average interval between the midpoints of the survey’s ranges from 1 to 6 years.
Surveys were carried out in the following years 1961, 1962, 1963, 1965, 1966, 1967, 1968,
1969, 1970, 1971, 1973, 1974, 1978, 1983, 1987, 1988, 1990, 1991, 1992, 1993, 1994, 1995,
1996, 1997, 2000, 2002, 2003, 2004, 2005, 2007, 2009, 2010, 2012 Because other data is
typically available on a yearly basis weighted interpolation has been used to generate poverty
measures for years where there was no NSS survey. The poverty lines recommended by the
Planning Commission; Government of India have been used. The head count data (2001-2015)
is estimated with PovcaINet World Bank
(http://iresearch.worldbank.org/PovcalNet/PovCalculator.aspxhttp://iresearch.worldbank.org/
PovcalNet/PovCalculator.aspx) which was recommended by Professor Ravallion.
Wage Agricultural wages data is from the Agricultural Wages in India (Ministry of Agriculture,
Government of India). The data spans the period 1961-2015. Factory wages data spans 1961-
2015. The source is the Annual Survey of Industries and are expressed in log real terms per
employee.
Employment data come from 1990-2008 National Sample Survey Office, Government of
India. The data refer to self-employment (which is, self-employed in agriculture or other
household activities like farming), second one as paid-employee (which is, regular worker and
casual labor on wage, working in agriculture or non-agricultural sector) and last variable for
the unemployed population.
54
Policy variables. Education and health expenditure data are from Public Finance Statistics
(Ministry of Finance, Government of India) and Report on Currency and Finance (Reserve
Bank of India) 1961-2015.
Politics variables Number of seats won by different political parties is from the Election
Commission of India state election reports.
55
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The Impact of Rural Banking on Poverty and Employment in India

Thesis · October 2019

Mazdi Husain Bukhari Syed

Empirical Study on Poverty View project

The user has requested enhancement of the downloaded file.

Rural India: An Empirical Study

Rural India: An Empirical Study

Professor Dr. Holger Seebens

Die Technische Hochschule Nürnberg Georg Simon Ohm

of the Requirement for the Degree of

Master International Finance and Economics (M.Sc.)

Mazdi Husain Bukhari Syed

1.1 Objectives of the Study ..................................................................................................... 5

1.2 Organization of the Study ................................................................................................. 5

2. Background of Study ........................................................................................................... 6

2.1. Bank Nationalization ....................................................................................................... 7

3. Structure of The Organized Banking Sector in India ....................................................... 9

4. Literature Review ............................................................................................................... 10

5.1. Program ........................................................................................................................ 20

5.2. Identification of Strategy ............................................................................................... 23

6. Basic Results ....................................................................................................................... 34

6.1. Reduced Form Evidence................................................................................................ 34

6.2. Instrumental Variable Evidence .................................................................................... 37

7.1. Rural Branch Expansion (success and limitations) ...................................................... 47

9. Data Appendix .................................................................................................................... 53

poverty and increasing employment opportunities.

gives people the power to rise out of poverty.” ― Muhammad Yunus,

be better able to exploit growth opportunities (Schumpeter, 1912; Gerschenkron 1962;

intervention of reducing poverty remains limited.

available in the data set.

commercial banks (unbanked locations).2

branch licensing policy.

1.1 Objectives of the Study

the following objective:

expansion) on poverty reduction and rural employment in India.

1.2 Organization of the Study

and conclusion in section 7 and 8 respectively.

of poor people in society.

2.1. Bank Nationalization

with an ordinance, which was called Banking companies'(Acquisition and Transfer of

ownership till 1969. At present, there are 19 nationalized banks in India.

There were two broad reasons behind the idea of nationalization:

II. Social Welfare

were the main objective of bank nationalization.

3. Structure of The Organized Banking Sector in India

maximization is not the intended primary goal of such banks.

Reserve Bank of India

Commercial Bank Co-operative Bank

Regional Urban State

Figure 1: Structure of Organized Banking Sector of India

(Goal 1 of Sustainable Development Goal). Therefore, with enhanced financial intermediation

reduce poverty to meet the goal of SDG.

Rural Banking Definition

population (Levine, 1999 and 2005).

Evaluation of financial intermediation through rural banking

many developing countries (Gonzalez-Vega, 2003).

(2) "#+ = &" + (# + /# × "1231 + 4# × 5"1231 + ,"#

(3) "#+ = &" + (# + /1 ("1231 × [< − 1961])

+/I ("1231 × J12KK ) + /3 ("1231 × J122L ) + /K (*"1231 × JBLLI ) + ,"#

(5) y"# = &" + (# + )"#+ + S1 ([< − 1961] × "1231 )